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Copyright © 2000 Addison Wesley Longman Slide #14-1
Chapter Fourteen
THE THEORY OF FINANCIAL STRUCTURE
Part V The Financial Institutions Industry
Copyright © 2000 Addison Wesley Longman Slide #14-2
Sources of
External Finance in U.S
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Sources of Foreign External Finance
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Puzzles of Financial Structure1. Stocks are not most important source of finance for
businesses
2. Issuing marketable securities not primary funding source for businesses
3. Indirect finance (financial intermediation) is far more important than direct finance
4. Banks are most important source of external finance
5. Financial system is among most heavily regulated sectors of economy
6. Only large, well established firms have access to securities markets
7. Collateral is prevalent feature of debt contracts
8. Debt contracts are typically extremely complicated legal documents with restrictive covenants
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Transactions Costs and Financial Structure
Transactions costs hinder flow of funds to people with productive investment opportunities
Financial intermediaries make profits by reducing transactions costs 1. Take advantage of economies of scale
Example: Mutual Funds
2. Develop expertise to lower transactions costs
Explains Puzzle 3
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Adverse Selection and Moral Hazard: Definitions
Adverse Selection:1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected
Moral Hazard:1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back
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Adverse Selection and FinancialStructure
Lemons Problem in Securities Markets1. If can't distinguish between good and bad securities,
willing pay only average of good and bad securities’ value.
2. Result: Good securities undervalued and firms won't issue them; bad securities overvalued so too many issued.
3. Investors won't want buy bad securities, so market won't function well.
Explains Puzzle 2 and Puzzle 1.
Also explains Puzzle 6: Less asymmetric info for well known firms, so smaller lemons problem
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Tools to Help Solve Adverse Selection (Lemons) Problem
1. Private production and sale of information— Free-rider problem interferes with this solution
2. Government regulation to increase information— Explains Puzzle 5
3. Financial intermediationA. Analogy to solution to lemons problem provided by used
car dealers
B. Avoid free-rider problem by making private loans– Explains Puzzles 3 and 4
4. Collateral and net worth— Explains Puzzle 7
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Moral Hazard: Debt Vs. EquityMoral Hazard in Equity:
Principal-Agent Problem1. Result of separation of ownership by stockholders
(principals) from control by managers (agents)
2. Managers act in own rather than stockholders' interest
Solutions to Principal-Agent Problem1. Monitoring: production of information
2. Government regulation to increase information
3. Financial intermediation
4. Debt contracts
Explains Puzzle 1: Why debt used more than equity
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Moral Hazard and Debt Markets
Moral hazard: borrower wants to take on too much risk
Solutions1. Net worth
2. Monitoring and enforcement of restrictive covenants
3. Financial intermediation— Banks and other intermediaries have special
advantages in monitoring
Explains Puzzles 1-4.
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Financial Development and Economic Growth
Financial Repression Leads to Low Growth: Why?1. Poor legal system
2. Weak accounting standards
3. Government directs credit
4. Financial institutions nationalized
5. Inadequate government regulation
Financial Crises
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Factors Causing Financial Crises1. Increase in interest rates
2. Increases in uncertainty
3. Asset market effects on balance sheets— Stock market effects on net worth— Unanticipated deflation— Cash flow effects
4. Bank panics
Financial Development and Economic Growth
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Events in U.S.
Financial Crises
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Events in Mexican and East
Asian Financial
Crises